The majority of our clients are at least a decade away from retirement, and most are still 20+ years out.  Yet all of our clients have at least a small portion of their portfolios allocated to bonds (via low-cost, passively-managed, diversified bond mutual funds or ETFs).

A reasonable question to ask – and one we hear frequently – is why own any bonds?  If the investor’s time horizon is “long-term” (say, 20+ years), and stocks have always outperformed bonds over the long-term, why not allocate 100% of the portfolio to stocks?

The answer is two-fold:

First, it is said that “diversification is the only free lunch in investing,” and adding bonds to a portfolio is the low-hanging fruit of diversification.  Reducing a portfolio from 100% stocks to 90% stocks (with the remaining 10% allocated to bonds) materially reduces its volatility while barely impacting its expected return[1]:

This is the magic of Modern Portfolio Theory, and foolish is the investor who passes it up.

Second, the time horizon argument addresses only one component of an investor’s risk tolerance, but risk tolerance is a function of three variables:

1. Ability to take risk, which is based on quantifiable data such as age, size of investment portfolio, expected retirement date, future earnings, and financial obligations.
2. Need to take risk, which is the minimum amount of investment risk necessary to achieve one’s financial goals.
3. Willingness to take risk, which is the human, emotional element that is difficult to quantify.

The time horizon argument only addresses the ability to take risk, which doesn’t always paint the full picture.  For example, what if an investor has a long horizon (ie, high ability) but is already safely on track to achieve his or her financial goals (low need) and has no appetite for financial risk (low willingness)?  Thoughtful portfolio design requires a consideration of all three.

What, then, is the appropriate allocation to bonds for a young-ish investor?  That can only be answered in the broader context of a holistic financial plan, and even then requires both art and science.  Acknowledging that the decision is more complex than simply measuring a time horizon is a good first step.

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[1] Annualized return and standard deviation data from 1/1/1926 to 3/31/2018 using CRSP Total Market Index for stocks and 5-Year US Treasuries for bonds.  (Source: DFA Returns Program.)

[2] The Sharpe Ratio measures the amount of return per unit of risk taken.  All else equal, a portfolio with a higher Sharpe Ratio is preferable to a portfolio with a lower Sharpe ratio.